TEN

Europe at the Crossroads

THE EUROPEAN PROJECT: FROM HOPE TO DOUBT

On a continent wounded by fratricidal wars, the European project to create an economic and political community on the continent aroused immense hopes. To secure peace and foster development, it proceeded over the years to thwart protectionism, ensure solidarity across countries, and modernize member states’ economies. The free movement of people, goods and services, and capital, was meant to prevent protectionism. As a guarantee of solidarity, structural funds were intended to help the economic development of poor regions. Finally, the European construction responded to a less overt wish on the part of southern European countries to delegate to a supranational authority the task of modernizing the economy through reforms, such as opening up to competition, which politicians considered necessary but did not dare to advocate on the national level.

In the context of the current euroskepticism, it is useful to remember that Europe has reduced inequalities among its member states and that European Union (EU) institutions have on the whole contributed to growth. The acquis communautaire (the accumulated body of European Union law comprising all of the international treaties, legislation, and judgments of the European Court of Justice since 1958) is sometimes criticized, but has nonetheless forced more rigorous management on previously dysfunctional economies, to the benefit of the people.

The creation of a common currency, the euro, an optional choice progressively adopted by nineteen countries by 2015, also inspired hope. Of course, many economists noted from the outset that Europe was far from satisfying the ideal conditions for a monetary union. The Eurozone has no fiscal mechanism to provide stability through automatic transfers from member states in good economic health to weaker ones (I shall return to this point in detail). Moreover, labor mobility is limited for cultural and linguistic reasons, and so the labor supply can only react minimally to regional demand—at the time of the euro’s creation, the mobility of workers between the states of the European Union was three times less than that between states in the US.1 These two classic stabilizing mechanisms to cushion regional shocks in federal states were absent, while the single currency eliminated the possibility of a country’s currency devaluing to restore the competitiveness to an economy experiencing a foreign trade deficit.

Even so, the euro represented an extraordinary symbol of European integration. It was intended to promote trade. Far more than a simple convenience for travelers who wanted to go from Barcelona to Toulouse paying in euros, the single currency eliminated exchange rate uncertainty and thus reduced the costs of volatile foreign exchange revenues. Indeed, trade between euro area countries increased by around 50 percent between the launch of the euro in 1999 and the peak of the Eurozone crisis in 2011.² We know how hard it is to limit the volatility of exchange rates, as demonstrated by the spectacular exit of the British pound from the European Exchange Rate Mechanism in 1992 following a speculative attack by George Soros’s Quantum Fund.

The euro was also intended to contribute to the stability of national economies by facilitating the diversification of savings across European countries: households and companies could invest abroad at lower cost, and their wealth was therefore less dependent on local conditions, which would also affect their jobs and order books. Indeed, diversification of savings is a major stabilizer across states in the United States. Finally, the euro was intended to facilitate the circulation of capital to the countries of southern Europe, strengthening their financial credibility and thus allowing them to finance their development.

Many supporters of the euro also saw it as a step on the path to greater European integration. They thought of the European Union, and then the euro, as stepping stones toward a federal Europe, either through the gradual emergence of a consensus in favor of greater integration, or because it would be difficult to reverse course—“we might as well go all the way.”3 This integration has not taken place so far, and it is doubtful that it will in the near future. Integration on this scale would have to be based on an abandonment of sovereignty far more extensive than has previously occurred, and on a mutual trust, a willingness to share risks, and a sense of solidarity—all things that cannot be forced and are barely present in the EU today. There is widespread disenchantment with the idea of Europe in general, and the euro in particular (although there are contradictions; for instance, a majority of people in the countries of southern Europe still favor remaining in the Eurozone).

How did we get here? Is there a future for the European project? To try to answer these questions, I will start by considering what led up to the euro crisis, and will then analyze the Greek crisis. Since the question of sovereign debt is so prominent, and is the source of the conflicts of recent years, I will ask more generally: How much can a country borrow while remaining in its comfort zone? Finally, I will turn to the central question: What are Europe’s options? My remarks thus focus on the crisis in the Eurozone, not on the centrifugal forces (such as the departure of the United Kingdom from the EU, for instance—or, conversely, the possibility of European Union enlargement) or noneconomic aspects (such as the retreat from European values in certain EU countries, such as Hungary).

THE ORIGINS OF THE EURO CRISIS

A DOUBLE CRISIS AND A NEW CULTURE OF DEBT

During the decade that followed the introduction of the euro in 1999,⁴ the southern part of the Eurozone developed two problems: competitiveness (prices and salaries increasing much faster than productivity) and excessive public and private debt.

Competitiveness

Figure 10.1 shows wage earnings from 1998 in Eurozone countries, and the striking contrast between Germany and southern European countries (France, Greece, Italy, Portugal, and Spain; France’s characteristics in this regard are much closer to those of its southern neighbors than to Germany). Germany has consistently practiced salary moderation (in a relatively consensual way, because the labor unions in the sectors exposed to international competition supported it), while salaries in the southern countries exploded. In the countries of southern Europe plus Ireland, salaries increased by 40 percent while labor productivity increased by only 7 percent.5 This divergence between salaries and productivity generated price differences: low prices for German products and high ones for those from southern Europe. Unsurprisingly, intra-European trade became massively unbalanced, with Germany exporting far more than it imported, and the southern countries doing the opposite.

Figure 10.1. Salaries and productivity in Europe, 1998–2013. Source: European Commission, Ameco database and Christian Thimann. Note: Greece does not appear on the graph; although the increase in Greek productivity is largely comparable to that of Portugal, the increase in salaries was even greater, rising in 2008 to 180 percent of the 1998 value and thus going off the scale of the figure.

What happens when a country imports more than it exports? To finance its net imports, the country (its firms, its public bodies, its households) must sell assets overseas. These assets may be acquired by individuals, investment funds, or foreign states—for example, 50 percent of the shares in French corporations listed on the CAC 40 stock index, as well as much real estate in Paris and on the Côte d’Azur, are now owned by foreigners. Alternatively, the government, the banks, or businesses must borrow money from abroad. In any case, the country is living on credit, choosing to consume more today and less tomorrow.

Eurozone imbalances ultimately raise questions about what caused the recent impoverishment of southern Europe. Although there is no question that the growth of salaries in relation to productivity in the south was excessively rapid, many observers also attribute some responsibility to Germany’s mercantilist policy. German policy has had contrasting effects on the citizens of other EU countries. On the one hand, consumers in these countries are pleased to be able to buy German goods at low prices. On the other hand, as employees of firms competing with German firms, they see their own employers struggling, not hiring, and even laying off people. The difficulties are exacerbated by the poor functioning of the labor markets in the south, reflecting policy choices in the countries concerned (see chapter 9).⁶

This is where the single currency poses a problem. If countries still had their own currencies, the German mark would have risen in value, whereas the French franc, the Italian lira, the Spanish peseta, and the Greek drachma would all have fallen. Consumers in southern Europe would have seen their purchasing power reduced by devaluation, but employees in sectors open to foreign competition would have been protected against large-scale job losses by the return to competitiveness.

Given that devaluation was not an option for the southern European countries, as they belonged to the Eurozone, the alternatives were also not very attractive.⁷ One option involved trying to reproduce the effect of a fall in the currency by means of what economists call a “fiscal devaluation,”⁸ which consists in raising taxes on consumption (the value-added tax, VAT) and thereby increasing the price of imports. The associated tax revenues are used to reduce the social security contributions paid by employers; this reduction in the cost of labor for domestic firms decreases the prices of domestic products and boosts exports. Such fiscal devaluation was practiced in several southern European countries, but only to a limited degree. A significant increase in VAT rates would have been necessary to compensate for losses in competitiveness ranging from 10 to 30 percent, which would have been inequitable and led to tax evasion.

The other substitute for currency devaluation, an overall reduction in salaries or prices that economists call an “internal devaluation,” was implemented in countries like Spain, Portugal, and Greece. This proved very costly; while salaries moved back toward their pre-Euro levels,9 the substantial increases that had taken place since then had created aspirations and commitments (for example, mortgage debts) in households that could not have anticipated the subsequent reduction in their incomes. Internal devaluations are also difficult to implement. States have direct control only over government salaries—they cannot guarantee that other salaries and prices will fall.

Debts

Was the crisis foreseeable? Take the case of Portugal, which experienced an economic boom in the 1990s in anticipation of joining the Eurozone. Olivier Blanchard and Francesco Giavazzi have shown that the inflow of money into Portugal during the 1990s fed the formation of a bubble rather than the development of a productive economy.¹⁰ The widening of Portugal’s current account deficit was chiefly explained by a decrease in households’ private saving rather than by an increase in investment.

More broadly, the confidence created by the poorer countries’ joining the Eurozone substantially lowered the interest rates paid by borrowers in these countries. The easier access to funds generated a capital inflow. This capital inflow, sometimes combined with weak regulation of banks’ risk taking, fueled asset price increases and created financial bubbles, in particular in real estate.

Massive levels of debt, both public and private, are implicated in the origins of the crisis that threatens the existence of the Eurozone today. Excessive borrowing was sometimes the fault of a spendthrift public sector or a failure to collect taxes (as in Greece), and sometimes the fault of the financial sector (as in Spain and Ireland). For example, when the Irish government budget deficit ballooned from 12 to 32 percent of GDP in 2010, it was because the banks had to be bailed out.

Reduced savings and increased consumption have a counterpart: the need to either sell assets or go into debt (or both). Selling the “crown jewels” has its limits as a strategy, especially because the jewels lose value as soon as a certain proportion is owned by foreigners: for instance, domestic companies, if in large measure owned by foreigners, are unlikely to get favorable treatment in terms of tax and regulations,11 and so foreign investors will not be willing to pay as much for them.

Debt also has its limits. There comes a time when foreign investors begin to have doubts about the ability of states—or their banks—to repay loans, and start demanding high rates of interest. They insist on “spreads,” that is, an interest rate above that paid by safe borrowers, or even simply refuse to grant loans.

However, as figure 10.2 shows, until 2009 Greece was able to borrow at a rate similar to Germany, even though the international investment community was largely aware of the problems in the country’s public finances. In other words, investors expected that Eurozone rules would not be observed, and bet that other Eurozone countries would bail Greece out.¹² Investors felt protected against the risk of default on Greek debt. More generally, they believed that there would be solidarity if a country in southern Europe got into difficulties. This was probably true, but only up to a point. In November 2009, the new Greek government revealed that the deficit was twice as large as the preceding government had previously announced, and that the nation’s debt exceeded 120 percent of GDP. As we will see, this triggered the crisis and later led investors to take a haircut on their investment.

Figure 10.2. Rates on ten-year government bonds. Source: Niccolò Battistini, Marco Pagano, and saverio simonelli, “systemic Risk and Home Bias in the Euro Area,” European Economy, April 2013, Economic Papers 494. The data are provided by Datastream.

Tolerating, or Encouraging, the Real Estate Bubble and Risk Taking

In their classic book This Time Is Different: Eight Centuries of Financial Folly, economists Carmen Reinhart and Kenneth Rogoff show that mistakes repeat themselves, and that many sovereign debt crises are the result of bubbles—often real estate bubbles—that governments have neglected or even encouraged.13 The reduction in the cost of borrowing in Spain after 1999 led to a Spanish real estate bubble that was financed by European capital. Unfortunately, it did not lead to investment in Spanish industry, which actually became less competitive. The borrowing was therefore not invested for the future. Moreover, it was a burden on the banks (in particular the regional savings banks known as cajas), which would later have to be bailed out by the Spanish government. The case of Spain is instructive. The large banks remained healthy,¹⁴ except for Bankia, which the state had to inject with capital equivalent to 2 percent of GDP (thus becoming its majority shareholder). Meanwhile, the cajas gambled on the real estate bubble, freely granting loans. When they got into serious difficulties, they were bought and recapitalized by the state.15

As I explained in chapter 6, politicians both federal and regional decided to ignore the central bank’s warnings, encouraging the real estate bubble. This benefited them politically, but did not put a brake on the risk taking by the cajas. The Spanish crisis might have been avoided if the banking union had existed at the time. The European Central Bank (ECB), which today oversees Eurozone banks, would hopefully have forced Spanish banks to slow their real estate lending. The German Landesbanken, which have strong political and regional ties, acted in a similar way. They too created major financial difficulties for their country.

The relaxed supervision around Europe affected private banks as much as public banks: Fortis, KBC, ING, Commerzbank, and several British and Irish banks had problems. If the Eurozone crisis had one virtue, it was in enforcing regulation of the banks at a European level, despite the reluctance of many politicians. These politicians were not only southern Europeans. Germany wanted to retain its freedom to supervise the Landesbanken, which were seen as a useful political tool. But national authorities supervising banking had a limited budget and supervisory teams unable to compete with those of the large banks. They could also simply close their eyes to a bubble. All of this made the case for the establishment of a single banking authority in the Eurozone, more removed from national pressures. This was implemented in 2014.

Whether because public spending was too high or banking supervision too lax, national debt reached high levels in southern Europe, as is shown by figure 10.3.

A FRAGILE DEFENSE

Although the architecture of the Eurozone leaves much to be desired, the authors of its founding 1993 Maastricht Treaty cannot be accused of not having foreseen the dangers. They were aware that member countries could spend too much, or underregulate their banks, while retaining easy access to financial markets if those markets assumed other member countries would support them. Consequently, the treaty introduced both a limit on budget deficits (in its initial form, 3 percent of GDP), a limit on debt (60 percent of GDP), and a “no bailouts” clause. It was later decided that these requirements had to flex with the business cycle (it is reasonable to run budget deficits during recessions), but the rules insisted that a balanced budget be maintained during normal times.

Figure 10.3. National Debt in EU countries as a percentage of GDP. Source: Eurostat, DebtClocks.eu.

These rules (known as the Stability and Growth Pact, enacted in 1997) had also provided for multilateral supervision. The European Union’s economic and finance ministers would ask for remedial action by any state guilty of budgetary backsliding as soon as the country’s budget deficit exceeded the 3 percent of GDP limit, other than in exceptional circumstances. In the absence of any meaningful action by the infringing country, the European Council could, in principle, levy a fine ranging from 0.2 to 0.5 percent of the country’s GDP. This policy was not very credible, because levying a fine on a state that is already in financial difficulty isn’t a sensible thing to do. The approach was refined in the budgetary pact of March 2012.16

So far, the Maastricht approach has failed. The combination of strict criteria with weak means of enforcement is an explosive mix.¹⁷ The approach has inherent difficulties: a lack of flexibility to accommodate the national context, the complexity of measuring debt, and the problem of how to monitor and enforce the rules effectively.

The “One Size Fits All” Problem

Although it makes sense from a political perspective, given a desire for equal treatment for all, uniform constraints for all countries do not make things any easier. There is no single magic number that determines the sustainability of national debt—what is sustainable for one country may not be sustainable for another. Argentina was in great difficulty with a debt of 60 percent of GDP, whereas Japan has exceeded 240 percent but has not (yet) triggered a crisis of confidence. When is public debt sustainable?

Sustainability depends on many factors. For example, a debt is more likely to be sustainable if, a) there is a high rate of growth so that tax revenues will increase, making it easier to service the debt; b) the debt is domestic—countries don’t like to default on their own citizens, banks, or central bank¹⁸ (this is why Japan’s debt, estimated at 240 percent of its GDP but with 90.6 percent held by Japanese investors, has up to this point not caused much concern);19 c) the interest rate is low (i.e., servicing the debt is cheap); or d) the government is easily able to collect higher taxes (for a given debt, countries with a weak tax-collection infrastructure, such as Argentina and Greece, are more in danger of crises; similarly, the United States has a greater margin for maneuver when it comes to increasing taxes than does France).

Other factors contribute. The prospect of support from other countries if things get really difficult makes it easier to go into debt, as in Greece before 2009; conversely, the financial markets’ perception that the federal government of the United States will not bail out a state or municipality limits how much its states and cities can borrow. The legal jurisdiction in which government sovereign debt is issued also plays a role; private creditors are often better protected, and thus more inclined to lend, if the bonds are issued in London or New York rather than in the borrowing country.

In addition, the willingness of a country to pay back its debts depends on the cost of defaulting, so this cost also determines its ability to borrow. There are several costs of defaulting. For example, the country can have difficulty borrowing again after default because it has shattered its reputation²⁰ (that is, markets no longer trust it), and because of the legal risk for new lenders and lenders who settle with the country to reduce its debt burden (creditors who have not been repaid and have not settled may be granted priority in repayment).²¹ Other costs of defaulting can include the confiscation of government-owned assets in other countries (for example, airplanes belonging to a publicly owned company) and general difficulty in trading goods and services internationally.

Finally, the higher the debt, the more problematic the situation, and the greater the probability that what economists call “self-fulfilling panics” occur. If lenders become worried about a country’s solvency, they demand higher interest rates, which in turn increases the cost of repaying the debt. This makes it less probable that the debt will be repaid, which “justifies” the market’s concerns and the lenders’ demand for a higher interest rate.²²

Ultimately, although there is agreement about the characteristics that determine whether or not a debt is sustainable, and agreement that large levels of debt can be dangerous for a country, it is difficult to identify precisely a maximum sustainable level of indebtedness.

The Difficulty of Measuring Public Debt

A country’s public debt consists only of financial obligations it is known for sure will materialize. This includes, for instance, government bonds and treasury bills that the government is in principle obliged to repay, whatever happens. But readers might be surprised to learn that their state pensions are not accounted for within public debt. They are “off balance sheet” to the extent that the state is not obliged to pay them (that is, governments can decide to reduce pensions, although they would certainly think twice before doing so). More than 90 percent of pensions in France are state liabilities that are not counted in public debt (as compared with 60 percent in the United Kingdom, and slightly less in the Netherlands). A recent study estimates that twenty countries in the OECD have unfinanced commitments to pensions amounting to seventy-eight billion dollars, in addition to their official debt of forty-four billion dollars.23 These are big sums.

Governments in all countries try hard to hide their debt in the form of contingent liabilities. Auditors try to discover these ingenious devices, which include guarantees backing various debts of public bodies or public-private partnerships, underfinanced pension funds, loans to risky countries through the intermediary of European institutions (such as the ECB or the European Stability Mechanism). Another problem complicating the calculation of government debt is that it accounts for liabilities but not future revenues. This creates an incentive to sell assets, sometimes at fire sale prices, to reduce the debt.

Another important part of the state’s contingent liabilities involve banking risk, as the recent examples of the United States, Spain, and Ireland clearly show. There is a limited probability that this risk will materialize, and it is therefore left off the books. What’s more, the stated amount—covered by deposit insurance—is often much smaller than the true amount. If the state must bail out depositors in the event that the deposit insurance system lacks sufficient funds, in practice it also bails out other forms of bank debts, such as the deposits of small and medium enterprises and bonds issued by the bank. Much of the debate on banking reform is really the question of what, and what not, to bail out.24 Sovereign debt issued by the state and private debt issued by banks sometimes need to be considered together. Private bank debt is partly public debt: if banks are weakened, so are the states in which they operate and vice versa. Yet for years, only public debt was considered in the Eurozone.

The Credibility of Reciprocal Monitoring

The Maastricht Treaty regarded monitoring government deficits and debts as the first line of defense, and a prohibition on bailing out member states as the second line. Neither of these has worked.

So far as monitoring is concerned, European finance ministers, gathered together in the Economic and Financial Affairs Council (ECOFIN), failed to punish numerous violations of the Stability and Growth Pact. There were sixty-eight violations even before the financial crisis began, and not one of them resulted in any intervention. Even France and Germany broke the rules as early as 2003. The European Union has also turned a blind eye to rule breaking in countries about to join the Eurozone or in those that became less vigilant once they joined. Italy is an excellent illustration. It made considerable efforts to reduce its debt before it entered the Eurozone, running a big primary surplus (that is, the budget surplus before interest payments), but as soon as it was in, it reduced its fiscal efforts. The damage was limited by low interest rates until the explosion of the Italian interest rate spread in the summer of 2011.

It is not surprising that mutual and reciprocal monitoring of the member states failed. A finance minister will be reluctant to anger fellow finance ministers from countries that have broken the rules by issuing a formal complaint, which is anyway unlikely to lead to any action. Political agendas also play a role. The objective of building a united Europe has often been invoked to justify turning a blind eye to dubious accounting practices, or to insufficient preparation for entering the Eurozone. Finally, every country might anticipate reciprocal favors when it needs them.

As for no bailouts, the European Union had to violate its own rules by coming to the aid of Greece. The same applies to the ECB, which acquired the public debt of countries in difficulty and accepted poor-quality collateral. For the time being, the no bailouts rule is not credible in Europe. Confronted by the fait accompli of a member state’s imminent bankruptcy, Eurozone countries may show solidarity (and have shown it in the past) simply out of fear of the “fallout” that sovereign default might cause. This includes both economic fallout (trade disruption, potential losses for companies and banks that have subsidiaries or other exposure in the defaulting country, or possible runs on other fragile countries’ debt) and other kinds of fallout (feelings of empathy for the troubled country, fearing for the future of the European project, or the nuisance associated with mayhem in the defaulting country).

The Comparison with the United States

To offer a comparison, in the United States (another monetary union),25 President Obama refused to bail out California in 2009; in 2014, the city of Detroit had to settle its debts in court: it was up to the state and the city to restore budget balance without counting on a bailout from the federal government. In fact, the United States federal government has not bailed out a state or city since 1840. The rare examples of default—for example, the rescue of New York City in 1975—led to strict subsequent supervision by the federal government.

That was not the case before 1840. During the War of Independence, several states went deep into debt and were on the verge of declaring bankruptcy. Then, and for almost fifty years thereafter, the federal government repeatedly bailed out troubled states. But a political consensus developed against bailouts in favor of fiscal discipline. Eyes are currently fixed on Puerto Rico, which is very poor (45 percent of its population living under the poverty line). In 2016, the federal government created a federal oversight board to negotiate the restructuring of Puerto Rico’s debt. After the negotiation with creditors failed, the federal oversight board filed for bankruptcy in May 2017, seeking the protection of US courts to reduce its debt burden.

The Cost to the People

The costs for overindebted countries begin mounting even before they default on their sovereign debt. Servicing the debt requires funds that could have been used elsewhere. The government finds it increasingly difficult to follow a countercyclical policy, allowing it to run a deficit if there is a recession or banking crisis, because borrowing to refinance its debt requires reassuring worried financial markets that it will observe budgetary rigor.

But, in the final reckoning, the total cost of borrowing is linked to the possibility of default. Like delinquent individual and corporate borrowers, defaulting countries need to renegotiate with creditors. The negotiation obviously cannot only concern a monetary compensation to creditors, since the borrower by definition is broke. Rather, the country must accept a range of concessions in terms of budget cuts and reforms, adopting policies that are meant to restore public finances, but that it would not have adopted by itself: defaulting involves a substantial loss of autonomy. When sovereign default is imminent, the hardest part for the negotiators is to make the necessary measures bearable for the citizens, while at the same time making sure that the efforts made are real. The sacrifices demanded must be fair, sparing only the most destitute. Reductions in military spending, reforms of the labor market and retirement systems, and the reinforcement and enforcement of taxation should be accompanied by an investment in export sectors, education, and productivity-enhancing infrastructure to prepare for the future.

Finally, since European institutions are too weak to create the conditions for a revival of trust in the crisis countries, recourse to the IMF was inevitable. It may be useful to restate the purpose of the IMF, because perceptions of its role are sometimes wrong. Simply put, the IMF provides services for countries in financial difficulties: no country is ever forced to use its services. Countries that ask the IMF for help generally no longer have access to capital markets—or, if they do, only at prohibitive interest rates that might trigger a spiral of high repayments, thus increasing the debt, increasing interest rates, and so on. The IMF supplies the country with liquidity. But that is not its main role, especially since its loans are almost always repaid and thus do not constitute genuine aid.26 The IMF sets conditions for more rigorous fiscal policy. It is this conditionality that helps these countries regain their credibility, so that international investors will once again agree to lend to them. We may criticize this or that condition that the IMF imposes, but its raison d’être is to help the country that has voluntarily appealed for its help.

Revisiting Moral Hazard

Earlier in this book, I mentioned moral hazard. Generally, the term refers to a situation in which the behavior of one party affects the well-being of another party (exercises an externality on that other party), and this behavior cannot be specified, in advance and in a credible way, in a contract. In the context of sovereign borrowing, “moral hazard” refers to the choices made by a borrowing country that will reduce the likelihood of the loan being repaid to the foreign lenders.

The persistence of budget deficits and their accumulation into debt springs immediately to mind. The choice to consume rather than invest is another example. And not all investment choices have the same effect on the sustainability of debt. Investments in the production of tradable goods increase a country’s capacity to repay its debt, while investment in nontradable goods decreases that capacity. This is because, to repay its debt, a country must sell goods abroad and not import too much. A (largely) nontradable good in which European countries (often via their banks) have invested is real estate, which is by definition “consumed” by residents.

Federal states like the United States or Canada have decided that the most reliable way to limit moral hazard is a rigorously observed no bailouts rule. That has been the case, as we have seen, in the United States since the 1840s, when the federal government refused to provide aid and eight states defaulted on their debts. In the twentieth century, Canada has also refused to bail out its provinces, although this has not resulted in bankruptcies. Argentina, on the other hand, bailed out its indebted provinces in the late 1980s. Ten years later, the same provinces were largely responsible for the country’s massive levels of debt, leading to the famous crisis of 1998 and the sovereign default in January 2002. A similar phenomenon occurred in Brazil, and interestingly in Germany, whose federal government has continually aided some of its Länder since the 1980s. It bailed out the city of Bremen and the Land of Sarre. That did not prevent budgetary excesses afterward—quite the contrary. The Länder were among the agents mainly responsible for excessive debt in Germany.27 This laxity was partly responsible for the European Stability Pact’s loss of credibility, because Germany and France secured changes to the pact to avoid having to pay penalties.

GREECE: MUCH BITTERNESS ON BOTH SIDES

Following the no vote on the referendum held in Greece on July 5, 2015, and the tense negotiations that followed it, European policymakers felt somewhat relieved. The Greeks had managed to stay in the Eurozone. They accepted the troika’s intrusive conditions (or stricter conditions, depending on one’s point of view), but they did not manage to get the debt restructured. Tourism, the main source of Greece’s export earnings, offered some relief for the country as many tourists were abandoning holidaying in North Africa and the Near East for security reasons. Countries in the rest of the Eurozone were glad that Greece had not imploded. They noted too that Alex Tsipras, the Greek prime minister, performing a volte-face in accepting conditions tougher than those he had denounced in calling the referendum, was supported by voters in elections in September 2015. After five years of crisis, with both camps stalling for time by trying to appease public opinion, European officials continued to focus primarily on the short term, with a narrow vision of the Eurozone’s future.

Even just focusing on the Greek problem, never mind the global situation of the Eurozone, opinions differ considerably. As Thomas Philippon, an economics professor at New York University, has emphasized: “Everyone seems to have an opinion about the steps that should be taken for the Greek economy and its mountain of national debt. But these opinions are for the most part arbitrary, and are often based on incomplete or incoherent reasoning.”28

Those who take the side of the troika²⁹ play down the fact that Greece has undertaken reforms, hesitant and incomplete though they may be. For the first time in many years, the economy expanded in 2014. Employees had borne nonnegligible decreases in their salaries, and the government had made efforts to cut the budget deficit and to reduce the size of the overinflated public sector.³⁰ Those on this side of the debate also fail to acknowledge that Greece’s recovery has been slowed down not only by bad policies but also by the extraordinary recession the country confronted. Investment in Greece came to a halt because investors were uncertain about demand and worried about possible expropriation in the future. They feared that their investments might later be subject to punitive taxation by a government concerned about either repaying the heavy national debt or continuing to finance public expenditure. As a result, unemployment even now remains extremely high, despite government attempts to challenge the labor market institutions inhibiting job creation. (Clearly, uncertainty as to whether these labor market reforms will be sustained has prevented them from achieving their full effect.) Some observers (although not the IMF) continue to dismiss the idea of debt relief, even though Greece is struggling to pay even the small amounts currently required (thanks to earlier restructuring of the debt, the maturities for repayment are very long and the real repayments will begin only in 2022).

Those in the anti-troika camp refuse to acknowledge that Greece has already benefited from substantial aid,³¹ and don’t propose any genuine economic reforms when they call for debt relief. So far, a number of reforms exist only on paper and have not yet been implemented. Tax privileges enjoyed by the wealthy, and the unequal treatment of salaried employees (who cannot escape taxation) and unsalaried individuals (who pay very little) have been criticized, but little has been done to change this. Little has been attempted to open goods markets, except for a few symbolic actions (such as relaxing regulations on the opening hours of pharmacies). There is still much that could be done on this front. Similarly, although limited progress has been made, the government continues to hold back private enterprise; international comparisons rank Greece low for the effectiveness of courts in enforcing contracts, or for making business easy to conduct. The suspension of collective agreements in certain sectors (such as public transport), along with legislation to encourage company-wide rather than branch-level union bargaining, is significant, but this decision may still be overturned. In general, the parties in power in Greece have the habit of systematically challenging what their predecessors have done, and this does not help the country.

The anti-troika camp also refuses to recognize that a certain amount of putting public finances in order (or “austerity,” as this camp calls it) was inevitable. As Olivier Blanchard, the IMF’s chief economist from 2007 to 2015, put it:

Even before the 2010 program, debt in Greece was three hundred billion euros, or 130 percent of GDP. The deficit was thirty-six billion euros, or 15½ percent of GDP. Debt was increasing at 12 percent a year, and this was clearly unsustainable. Had Greece been left on its own, it would have been simply unable to borrow. Given gross financing needs of 20–25 percent of GDP, it would have had to cut its budget deficit by that amount. Even if it had fully defaulted on its debt, given a primary deficit of over 10 percent of GDP, it would have had to cut its budget deficit by 10 percent of GDP from one day to the next. This would have led to much larger adjustments and a much higher social cost than under the programs, which allowed Greece to take over 5 years to achieve a primary balance.32

By demanding the cancellation of the debt and the creation of the equivalent of Brady bonds,³³ the anti-troika camp correctly wonders about the country’s ability to repay the debt without tremendous social cost; but it does not take into account that Eurozone countries, unlike the commercial banks that were the creditors of Latin American countries that defaulted in the 1980s, do not have the option of keeping their distance after the debt has been restructured. Their well-being is tied to Greece’s, and the restructuring of Greek debt will not necessarily end their financial involvement in the country. Although I consider Greece’s debt unsustainable, and very likely to weigh on the country’s future, the situation is more complex than the proposal to simply forgive the debt would suggest.

A CONFRONTATION IN WHICH NO ONE COMES OUT A WINNER

There are good reasons for concern. First of all, about economic performance. Investment in Greece may not resume in the short term. Since the banks’ balance sheets are weighed down by unproductive loans to enterprises, mortgages, and holdings of government bonds, the banks need to be recapitalized (a point the ECB has started to insist on) so that they can start to fund productive investment. And foreign investors’ trust must be restored.

Nor is there any guarantee that an intrusive approach will necessarily pay off. If we examine the privatizations being asked of Greece, we may agree that the management of public assets should not be left to a ruling elite. But selling them off cheaply will help neither the Greek government nor, indirectly, its creditors. Domestic buyers with cash on hand are scarce, and foreign buyers offer low prices because they fear, logically enough, that government policies intended to satisfy local interest groups or to raise funds to reimburse the debt will swallow up part of their investment. Here again the lack of long-term clarity has far-reaching consequences.

The second source of uncertainty concerns relations within Europe. The relationships between the peoples of the European Union, which the founding fathers conceived as a way to promote peace on the continent, are steadily deteriorating. With the improvement of the situation in Portugal, Ireland, Italy, and Spain, the insulting group acronym “PIIGS”34 has disappeared, but we are witnessing a resurrection of old and very sad clichés about nationalities, in particular Germans and Greeks. Populists on the left and especially on the right opposed to a united Europe are daily winning more voters.

Agreements are also more and more often obtained by making threats. An instance of political arm wrestling occurred in July 2015. On one side was the Greek government, which used Greece’s exit from the Eurozone—“Grexit”—as a threat. A Grexit would expose Eurozone countries to geopolitical upheaval in the Balkans, to a repudiation of Greece’s debt (which will occur to a certain extent anyway, but whose recognition governments prefer to delay for electoral reasons), and to the blame for whatever might happen to Greece. On the other side, the rest of Europe, which won a short-term “victory,” was motivated by the desire to send European populist movements the message that there is no free lunch, and to underline the potential humanitarian and economic consequences of Grexit for Greek citizens. The Greeks understood that a return to a devalued drachma (though the devaluation by itself would not be the end of the world) would involve dealing with complex legal problems and with further capital flight, balancing their budget, submitting to sanctions, suffering another short-term decrease in productivity, coping with increased inequality, and perhaps losing some of their acquis communautaire35 under pressure from powerful populist parties. Leaving the euro is quite different from not joining it in the first place.

Two EXTREME SCENARIOS: GREXIT AND THE ENTRENCHMENT OF THE TROIKA IN ATHENS

Prior to the 2015 referendum, the press commented extensively on the possibility that Greece might leave the Eurozone, or even the European Union. The Greek finance minister even made a contingency plan for leaving the euro shortly before the referendum, and his German counterpart spoke of a “temporary” Grexit.

The benefit for Greece of leaving the euro would be that it would very quickly recover its competitiveness; the depreciation of the drachma that would follow would make Greek goods and services cheap and imported goods expensive. This would revive economic activity and create employment. As I have said, this exit from the euro would prove very costly for Greek citizens, however, quite apart from their loss of purchasing power. First, it would lead to a default by the state and the Greek banks, which would have trouble repaying debts denominated in euros using their devalued currency. The Greek state would have to redenominate the banks’ liabilities (and assets) and their contracts more generally into the local currency. Argentina did this in 2001, calling it “pesification.” This is effectively default by another name, and would avoid neither international sanctions nor an additional loss of reputation for the country. Greece would be unable to borrow from foreign lenders for a while, and would have to instantly balance its budget. Greece would also lose the five billion euros it receives every year from the EU. Since it joined the European Union in 1981, Greece has been a major beneficiary of EU funds. Europe, having become its main creditor in recent years, would feel justified in withholding structural funds if loans were not repaid. Finally, Greece would see levels of inequality, already high, skyrocket. Greeks who had invested their money abroad would become much richer thanks to the fall of the drachma, whereas ordinary citizens would see their purchasing power fall even more. Reducing this inequality would require a much better performing fiscal administration.

Opinions differ regarding the possibility of contagion, the prospect that Greece’s problems might spread to other European countries. This would not be through cross-exposure: unlike 2011, when the first bailout occurred and a default would have meant major losses for German and (especially) French banks, European banks no longer had many assets in Greece by 2015. The divergence in opinion instead rests on the impact that Grexit would have on other fragile countries. One camp maintains that the financial markets would panic because leaving the euro would no longer be taboo. Another, more interesting, version of the same argument is that the financial markets are learning that the Eurozone is no longer going to insure the debts of one of its members—which it had already begun to suggest by imposing losses on the Greek state’s private creditors in 201236 and, in Cyprus in 2013, on depositors who had no deposit insurance. In contrast, others argue that leaving the euro, because it would be costly for Greece, would weaken populist movements in other countries in southern Europe exploiting anti-euro sentiment. This camp adds that firmness in negotiating with Greece benefits the countries that have made greater reform efforts, or that had not benefited from the transfers granted to Greece (Spain, Portugal, Ireland, and eastern Europe). These countries were, notably, Germany’s allies in demanding firm treatment for Greece.

Grexit is a risky option, but so is business as usual. It is fine to stall for time, but to avoid eventual ruin, politicians should reflect on the bigger challenges of the Eurozone. Whatever your opinion, there should be a consensus on at least a few points:

1.  The troika cannot continue to run Greece jointly with its government for the next thirty years. The Greek debt of 180 percent of GNP—characterized by a high rate of foreign holdings—is gigantic for a country with limited fiscal capacity, and has a long maturity (about twice as long as that of other national debts) and a low interest rate, following the restructurings of 2010 and 2012. Payments are due to become large only after 2022, and then will be made over many years. Can we envisage the troika in charge for such a long time? The referendum and the popular discontent in Greece have shown the predictable limits of this exercise. Besides, the IMF is generally brought in by a country in difficulty so that it can reestablish its credibility and overcome a short-term liquidity problem. Democracy requires that the IMF’s intervention is temporary.

2.  In Greece, investment (and consequently employment) has little chance of recovery as long as there is no long-term certainty.

3.  Reforms are better than austerity, even if we have to admit that their exact nature is difficult to specify in an agreement.

4.  Debt relief is necessary, but it merely creates breathing room, which makes it likely that the question of further debt relief will come up later.

5.  Solidarity and responsibility go hand in hand. Europe needs a little more of both.

6.  Solidarity is a political decision. The ECB plays its role by providing liquidity in a countercyclical manner (that is, when there is a recession or the threat of a recession) and punctual aid to prevent problems from spreading, but it should not be obliged to provide permanent support to struggling countries just because an unelected body can do this more easily than a parliament. If this was allowed to happen, the ECB’s (indispensable) independence could be compromised. Politicians should assume their responsibilities.

7.  By providing liquidity for the Eurozone, the ECB gives it the time and the opportunity to get out of a rut. But the ECB alone cannot solve the problems that created that rut. Individually and collectively, member countries must take advantage of the breathing room accorded by the ECB to reform their institutions.

WHAT OPTIONS DO THE EU AND THE EUROZONE HAVE TODAY?

The founders of the European Union had a long-term vision for managing the potentially dangerous postwar period, and in 1957 they were able to mobilize enough political support to construct a community of states. Today, we once again need a long-term vision. For the Eurozone (to simplify dramatically) there are two strategies. The current strategy is based on an improvement of the Maastricht Treaty. It does not provide for automatic stabilizers, such as a shared budget (implying the partial or full pooling of tax revenue), common deposit and unemployment insurance, and borrowing under joint and several liability, that would make it possible to stabilize a member state economy in difficulty. This strategy implies limited risk sharing.

The second, more ambitious solution would be federalism, which implies greater risk sharing. The 2012 banking union37 is an embryonic form of federalism. If it is accompanied by deposit insurance guaranteeing deposits of ordinary savers in Eurozone banks, which are themselves centrally monitored, it will be a major step toward sharing risks with limited moral hazard for its member states (who no longer supervise their own national banks). Although opinions on this subject differ, the banking union, executed correctly, is a game changer. Obviously, European banking supervision is still in its preliminary stages and must prove its independence from the member states and the banking sector. In addition, some characteristics of banking supervision (particularly its limited coverage in political debate and in the media) have facilitated the abandonment of sovereignty through the creation of the banking union, but may be lacking in other kinds of action moving member countries toward a federalist state. Thus it is not certain that people will so easily accept the next steps toward European federalism.

I wonder whether Europeans and their leaders are fully aware of the conditions that must be met for either of these approaches to work: one cannot simultaneously insist on more sovereignty and greater risk sharing. This is the heart of the problem.

THE IMPROVED MAASTRICHT OPTION

The Maastricht approach infringes on the sovereignty of member states only with respect to monitoring government debt and deficits by the Eurozone.38 In theory, it excludes bailouts. In practice, when faced with a member state in difficulty, the Eurozone countries tend to stand together. As we discussed, such solidarity may be motivated by financial interest, empathy to the plight of troubled countries, or fear of geopolitical repercussions if they do not assist. Regardless of the motivation, this unplanned (or ex post) solidarity is necessarily limited, however, as is also shown by the heated debate over who would be the winners and losers from a German fiscal stimulus.

This limited solidarity raises the question of why countries do not create a formal insurance mechanism in which they commit to come to each other’s rescue. One such scheme is the joint issuing of debt for which they would be collectively responsible under joint and several liability; if a state defaulted, its debt would be assumed by the other states. However, as I have indicated in a recent article,³⁹ while healthy countries can always express their solidarity ex post during a rescue operation, they have no incentive to tie their hands ex ante. That is, they have little interest in contributing more insurance to the countries that are most at risk than what they would voluntary contribute ex post if the latter got into trouble, because the countries at risk cannot indemnify them for the cost of this commitment without borrowing even more.

The Achilles’ heel of the Maastricht structure is the management of deficits, which is economically unsatisfactory, as we have seen, but is also undermined by a lack of political will to intervene early—at a point when (fiscal) rigor would be least costly. Some progress has been achieved by reforms called the “Two-pack,” which embody an external examination of budgetary policies. But their effectiveness is yet to be tested. If a country fails to respect the rules, it is not clear that anyone has the power to enforce them.

Given that the political process has little chance of producing the hoped-for results, the Maastricht approach seems to require the establishment of a highly professional and independent fiscal council that would intervene when there is an unsustainable deficit, but would not advise whether the country should decrease expenses or increase taxes to reduce it, nor suggest the appropriate composition of expenditures and revenues. A recent innovation is the introduction, in the member states, of independent fiscal councils similar to the Congressional Budget Office in the United States (they already existed in some European countries, such as Germany and Sweden). An independent evaluation by experts40 is useful for identifying anomalies. For example, most governments make systematically optimistic forecasts for growth. This inflates their forecasts of tax revenues and underestimates the likely cost of social programs, such as unemployment benefits, and so allows them to appear not too much in deficit. Sometimes independent fiscal bodies have a broader mandate. The Swedish Fiscal Policy Council, for example, also evaluates the consequences of government policies and their viability.⁴¹

Unlike the national fiscal councils that were imposed on the member states in 2011, this fiscal council would have to be European (the basic problem is, after all, the “agency” that exists between Europe and its member states) and capable of requiring prompt corrective action. In addition, given that financial sanctions are not a good idea if a country is already in financial difficulties, other measures must be used, although these will only sharpen the populations’ concerns about legitimacy and sovereignty. As things stand, the current impulse toward national sovereignty works against such improvement of the Maastricht approach.

To sum up, no matter how appealing it was to introduce independent fiscal councils in 2011, we should not expect miracles. It is unfortunate that their members are citizens of the countries concerned, even though the mission of the councils is to stand for European, not national interests. Above all, such bodies do not resolve the question of what to do when a country does not respond to warnings, which is far from a theoretical possibility.

THE FEDERALIST OPTION

A Greater Sharing of Risks

Starting with the United States at the end of the eighteenth century, many countries reacted to the difficulties of their member states by increasing the federal capacity to go into debt and by introducing systematic fiscal transfers among their members. The federalist approach inevitably implies greater risk sharing than the Eurozone countries currently allow. Full integration would make Eurozone countries jointly responsible for the debts of other member states through the issuance of euro bonds, that is, bonds issued jointly by the states of the Eurozone, the repayment of which they would jointly guarantee. A joint budget and shared deposit insurance and unemployment insurance schemes would also act as automatic stabilizers, offering more protection for countries in temporary difficulties. For example, the income tax—not least because it is a progressive tax—effects major transfers from wealthy regions to poor regions, which have expenses (retirement pensions, health care) as costly as those of other regions.

The practical importance of this risk sharing in federal countries is debated. In federations like the United States, the extent of this kind of stabilization seems empirically limited, and less important than the stabilization operating through the financial market—that is, through the diversification of the portfolios held by individuals and enterprises far beyond the boundaries of the state.42 In any case, the sharing of risk may have helped make the no bailouts policy more credible. Recall that since the 1840s the United States federal government no longer bails out the states: the existence of stabilizers perhaps reduces the number of excuses for poor performance.

The Prerequisites for Federalism

The federalist vision requires that countries meet two preliminary conditions. First, every insurance contract must be signed behind the veil of ignorance. You wouldn’t sell me insurance if you suspected that my roof had a good chance of falling in tomorrow. That is why a high degree of risk sharing is probably unacceptable for the countries of northern Europe. The asymmetry between north and south might be corrected by identifying and isolating the problems inherited from the past and dealing with them adequately. Doing so is complex, but this problem can be solved. For example, in introducing a European system of deposit insurance, the troubled assets held by banks in difficulty could be dealt with by creating “bad banks” to hold these assets in each member state.

A second and much more fundamental point is that countries living together need common rules to limit moral hazard. Common rules should concern those areas of potential mismanagement that can force a country to ask for help. We have seen that the supervision of banks should not be carried out at the country level, because the banking sector and the politicians then have too much influence over the process. The case of a common system of unemployment insurance is more complex. The unemployment rate in Eurozone countries is only partly determined by the economic cycle, which by itself would justify a mechanism of insurance among countries. It also results from choices about job protection, active labor market policies, contributions to social security, occupational training schemes, collective negotiations, and the protection of professions, among other things. Those countries whose institutions produce an unemployment rate of 5 percent will not wish to be part of a shared insurance system with those whose choices create a 20 percent unemployment rate. The same goes for pension and legal systems. Many Europeans, however, including some who claim to be federalists, are still opposed to the idea of surrendering more of their sovereignty.

The federalist approach will not be made more acceptable by the mere creation of a European parliament with extended powers. First there must be an agreement on a foundation of common laws and regulations, as was the case—in a more modest way—during the initial phase of the European project, and then in the gradual construction of the acquis communautaire. The countries that have undertaken painful political reforms might fear seeing their own acquis disappear. More generally, each member state will fear that the profound contractual incompleteness of a top-down “political Europe” will produce a result even more distant from its aspirations than what we have today. The consequences of federalism should be understood by everyone before we set out on this path.

The Limits of Solidarity

Federalism is sometimes much more than an insurance policy between regions of a single federation. In other words, transfers between regions can be more structural than conditional. In the United States, wealthy states like California and New York systematically and substantially subsidize the poor states, like Alabama or Louisiana. During the past twenty years, New Mexico, Mississippi, and West Virginia have received on average more than 10 percent of their GDP this way. Puerto Rico currently receives 30 percent of its GDP from the rest of the United States. Germany makes large, regular transfers between its Länder, which all receive about the same amount per inhabitant. Italy transfers resources from the north to the south, the UK from the south to the north, and Catalonia to the rest of Spain. In Belgium, Flanders transfers funds to Wallonia, whereas financial flows used to move from Wallonia to Flanders.

In the end, everything depends on the willingness of wealthy regions to finance poor regions. We still have an imperfect understanding of what would determine this willingness. Clearly a common language and nationalist feeling help generate the unidirectional transfers in Italy. It can also be argued that the strong separatist movements in regions like Catalonia in Spain and Flanders in Belgium are linked to a sense of cultural and linguistic distance. More generally, the welfare state is usually more developed in homogeneous communities.43 What is true for regional governments is probably also true at the national and international levels. For better or worse, groups are more receptive to redistribution when the beneficiaries are close to them culturally, linguistically, religiously, and racially.

And Now

It is hard to say in advance what path Europe will take to solve its problems. Perhaps it will be a revision of the Maastricht approach, accompanied by specific—but necessarily limited—integration using the model of the banking union. But if we Europeans want to live together, we have to accept the idea of losing a little more of our sovereignty. To achieve this in an era of increased nationalistic fervor, we must rehabilitate the European ideal and remain united around it. This is no easy task.